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European Insurance Capital Requirement Tests and Implications for Asset Selection July 2017

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European Insurance Capital Requirement Tests and Implications for Asset Selection July 2017 European Insurance Capital Requirement Tests and Implications for Asset Selection July 2017 Why Convertible Bond Strategies Make Sense Given Solvency II & Other Regulatory Market Stress Tests Executive Summary The European insurance industry capital regulations called ‘Solvency II’, which came into effect in 2016, have created constraints on the assets insurers can hold and the risks that can be taken. This paper demonstrates how convertible bond investment strategies can provide significant capital requirement relief without sacrificing insurers expected return on invested assets. Convertibles have three key advantages. • Since tracking began, convertible bonds have had better risk adjusted returns than other asset classes, and perform especially well in periods of rising interest rates. • The structure of the Solvency Capital Requirement tests is favourably disposed to convertible strategies. — The equity test does not penalise higher volatility or beta investments. This is advantageous to convertible portfolios since convertible bond issuers tend to have higher volatility equity prices. — The ‘cyclical adjustment’ highlights the value of the convertible ‘bond floor’. — The spread test is relatively less severe on lower duration assets. This is advantageous to convertible portfolios since convertible bonds have very low effective duration. — The interest rate test favours assets that have a short duration relative to their maturity. The ratio between a convertible bond’s duration and its maturity is low. — The concentration test incentivises diversification across issuers. There is little issuer overlap between convertible bond indices and straight debt or equity indices. — Long only convertible funds can provide asymmetric returns with comparable upside to equities, but with significant downside protection. Balanced convertibles1 can be a risk reducing substitution to equities, and defensive convertibles2 can be a return enhancing substitution to fixed income. — Strategies with a short equity component such as convertible arbitrage3 are an especially valuable tool for achieving capital relief, when combined with insurers’ equity portfolios. • A capital constrained insurer can reduce capital requirements and boost upside returns significantly by substituting convertibles for either equity or fixed income assets. — In a 60/40 portfolio, substituting 10% balanced convertibles for 5% investment grade corporate bonds and 5% equity potentially reduces capital requirements on the whole portfolio by 133-155 bp (~5%), and can boost total portfolio upside returns by 86-128 bp (~4%). — For an equity portfolio, a 10% substitution to hedged convertibles can reduce capital requirements by 717 bp (~13%); while a 10% substitution to balanced or defensive convertibles can reduce capital requirements by 400-459 bp (8-9%) respectively without significantly affecting upside return (-183 bp to -304 bp). — For a fixed income portfolio, a 10% substitution to investment grade defensive convertibles can reduce capital requirements by 20 bp (4%) while potentially boosting upside return by 252 bp; and a 10% substitution to hedged convertibles can potentially boost upside return by 309 bp for the same level of capital. A 10% substitution from investment grade to a blend of convertible strategies can reduce capital requirements by 31 bp (6%), while increasing the upside return by 295 bp. 1 Balanced convertibles: Convertible Bonds with Delta (Equity Sensitivity) between .40 and .80. 2 Defensive convertibles: Convertible Bonds with Delta (Equity Sensitivity) less than .40. 3 Convertible Arbitrage/Hedged Convertibles: An investment strategy wherein a portfolio is comprised of long convertible bonds and short equity positions. Typically the short equity position neutralises all or almost all of the equity sensitivity of the convertible bonds. In this study the convertible arbitrage metrics were modeled using a representative-asset method in the KYNEX risk system. ADVENT CAPITAL MANAGEMENT, LLC New York | 1271 Avenue of the Americas, 45th Floor, New York, NY 10020 | + 1 212 482 1600 London | 4th Floor Devonshire House, 1 Mayfair Place, London W1J 8AJ, UK | +44 203 357 9990 1 of 12 European Insurance Capital Requirement Tests and Implications for Asset Selection Long Term Performance of Convertible Bonds4 Figure 1: Returns and Standard Deviation of Returns By Asset Class 11% Convertibles have been the best performing asset class Convertible Large Cap Bonds since tracking began (December 1972) with returns 10% Equity comparable to large cap equity, but at significantly 10% lower volatility. 9% High Yield Convertible bonds have outperformed investment 9% grade debt, high yield debt, and small cap equity in Return Total 8% terms of both absolute return and Sharpe ratio. Small Cap 8% Inv. Grade Equity Bonds Since 1972, in up years convertible bonds have captured 7% nearly 90% of the S&P 500, while in down years, the 5% 10% 15% 20% Standard Deviation decline was nearly 60% less than the S&P 500. S&P 500 Avg. Convertible Bond Participation Rate Return Avg. Return Up Years 15% 13% 88% Down Years -12% -5% 42% Performance of Convertible Bonds During Periods of Rising Interest Rates5 Because of their low duration, positive interest rate convexity, and asymmetric equity sensitivity, convertibles historically outperformed many other fixed income asset classes in periods of rising interest rates. In the ten periods since 1992 when the 10-Year Treasury yield rose by at least 100 bp, convertibles have outperformed many other fixed income Figure 2: 65% 58.7% 60% Convertibles (VXA0) 57.5% 55% 10-Year Treasury (GA10) IG Corporates (C0A0) 49.1% 50% HY Corporates (H0A0) 45% Bank Loans 40% 35% 33.9% 30% 25% 19.8% 19.2% 20% 14.4% 15% 13.8% 11.7% 12.3% 10.3% 10.0% 9.4% 9.5% 10% 8.6% 8.5% CumulativeReturn 5.6% 6.2% 6.8% 6.3% 6.3% 6.3% 4.8% 4.9% 4.5% 4.7% 4.2% 5% 3.9% 1.4% 3.1% 0.9% 0% -0.2% 0.0% -1.3% -2.2% -2.0% -2.0% -2.5% -5% -3.2% -4.3% -5.5% -5.4% -5.8% -6.0% -10% -6.8% -8.7% -7.9% -9.7% -10.8% -10.1% -15% 9/30/93-11/30/94 12/31/95-8/31/96 9/30/98-1/31/00 10/31/01-3/29/02 5/31/03-5/31/04 6/30/05-6/30/06 12/31/08-12/31/09 8/31/10-3/31/11 7/31/12-12/31/13 7/31/16-1/31/17 Rise in 10-Year 252 bps 137bps 225 bps 116 bps 128 bps 122 bps 163 bps 100 bps 156 bps 100 bps Treasury Yield Convertibles (VXA0) 10-Year Treasury (GA10) IG Corporates (C0A0) HY Corporates (H0A0) Bank Loans 23.5% -9.4% 0.5% 13.9% 9.0% 4 Source: Bank of America Merrill Lynch and, prior to June 1992, Ibbotson Associates. Investment Grade Bonds are represented by the Bank of America Merrill Lynch Corporate and Government Master Index (B0A0). High Yield Bonds are represented by the Bank of America Merrill Lynch High Yield Master II Index (H0A0). Convertible Bonds are represented by the Bank of America Merrill Lynch All U.S. Convertibles Index excluding Mandatories (V0A0). Large Cap Equities are represented by the S&P 500 Index. Small Cap Equities are represented by the Russell 2000 Index. Past performance is not a guarantee of future results. Up/down years are defined as years in which the S&P 500 posted a positive/negative return. Participation rate is the convertible average annual return divided by the S&P 500 average annual return. Information shown is from the period 12/31/1972 through 5/31/2017. 5 Sources: Bank of America Merrill Lynch Convertible Research; www.federalreserve.gov; Bloomberg, Credit Suisse. VXA0 is the Bank of America Merrill Lynch All U.S. Convertibles Index. GA10 is the Bank of America Merrill Lynch Current 10-Year U.S. Treasury Index. C0A0 is the Bank of America Merrill Lynch Corporate Master Index. H0A0 is the Bank of America Merrill Lynch High Yield Master II Index. Bank loan performance is represented by the Credit Suisse Institutional Leveraged Loan Index (CSILLI). Periods of rising interest rates are defined as an increase in the 10-year Treasury Yield of 100 basis points (1%) or more. Information is shown for the periods since the inception of CSILLI on January 1, 1992. ADVENT CAPITAL MANAGEMENT, LLC New York | 1271 Avenue of the Americas, 45th Floor, New York, NY 10020 | + 1 212 482 1600 London | 4th Floor Devonshire House, 1 Mayfair Place, London W1J 8AJ, UK | +44 203 357 9990 2 of 12 European Insurance Capital Requirement Tests and Implications for Asset Selection assets by a wide margin. On average, convertibles have returned 23.5% versus 13.9% for high yield and 9% for bank loans, while investment grade corporates were flat, and 10-Year Treasuries lost -9.4%. They have outperformed other fixed income asset classes in eight of the ten periods, with negative returns only from September ‘93 - November ‘94, when small cap equities were down -3.50%. European Insurance Regulatory Regime The European Insurance Regulatory body, EIOPA, has instituted a regulatory capital regime which came into effect in 2016 called Solvency II. The purpose of Solvency II is to minimise the risk of widespread industry failure. Specifically, the regulatory body seeks to ensure that insurers have sufficient capital to survive a “one in two hundred year” risk scenario called the Solvency Capital Requirement (SCR) test. To this end, they have crafted a series of stress tests intending to model the effects of a worst case scenario on all parts of an insurer’s business. There are several “modules” that provide stress test details, parameters, and required formulae that focus on both assets and liabilities. The structure of the EIOPA is to provide detailed methods, templates, and standardization. However, the execution and compliance verification are largely left to country specific insurance regulators.
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